Monday, April 23, 2012

Leasing Office Space - Expenses

When do You Start Paying for Office Space?

Tenants are generally provided time to prepare the office space for occupancy prior to the date when they must begin paying rent. However, in hot markets and for some very desirable properties or spaces, landlords will be able to require that tenants pay for office space beginning at the time the lease is executed. In such cases, it is possible the tenant will pay for space for four to 12 months, or even longer, prior to commencing operations within the office space. However, this is the exception rather than the rule. In most cases, tenants are provided a reasonable amount of time to prepare the space for occupancy.

What Happens if Office Space is Not Ready on Time?

The lease should address the contingency regarding what happens if it is not possible to occupy the office space on the contemplated date. For example, there could be delays in obtaining signage permits, usage permits, construction permits, and in completing construction due to a union strike.

TI Details

If the landlord is providing a tenant improvement (TI) allowance, what are the mechanics of performing the construction and funding the cost of construction? If the cost of the construction is less than the TI allowance, is the tenant allowed to keep the excess funds? Is union labor required?

More TI Details

Is the tenant required to use a general contractor? Should the landlord be compensated for inspecting construction? Alternatively, is the landlord required to provide space which complies with an agreed-upon set of plans at its own expense?

ADA Compliance Expenses

If the space is not currently ADA compliant, who should pay for the cost of making it ADA compliant?

Operating Expenses for Office Space

Office space expenses are typically paid by the landlord. This includes items such has common area utilities, common area maintenance, insurance, property taxes and management. Tenants often pay an allowance for expense escalations for operating expenses above a defined level. Operating expenses for escalation do not include items such as tenant improvements, leasing commissions and interest.

Depreciation

Non-cash expenses such as depreciation and amortization would not be included. While each lease is negotiable, most office leases utilize a gross rent basis with the tenant paying an expense escalation. However, this varies from market to market.

Who Pays for Repairs and Replacements for Tenant Space?

Repair and replacement of the roof is typically handled by the landlord. However, in some leases the tenant is responsible for this expense. Repair and replacement of the HVAC system can be a negotiated matter. In most offices the landlord pays for HVAC repair and replacement.

Brokerage Fee

Payment of the brokerage fees should be addressed in the lease. If a tenant rep broker has been working with you to find office space, you probably signed a representation agreement prior to working with the broker. This agreement would likely provide your commitment to work exclusively with the broker for a defined period. (Include a 30 day cancellation clause in case you are not satisfied with the work performed by the broker. In many cases, this agreement would still provide a level of protection to the broker if you lease space he suggested.)

Document the Brokerage Fee, Even if You are not Paying

Your agreement with the broker should also document who is responsible for paying the brokerage fee. In most cases, this will be the landlord. However, even if you have already documented your agreement with the broker, it is better to affirm the agreement within the lease to avoid a misunderstanding.

Expense Escalations - Who Pays When Operating Expenses Increase?

Expense escalations are relevant when the landlord is paying a base level of expenses and when the tenant is paying expenses in excess of the base. With a typical gross lease, the landlord pays all expenses and the tenant pays expenses in excess of a base level. (Gross leases are typical for office.) The base level is typically the operating expenses for the year the lease is signed. The "expense escalations" would be expenses in excess of this base level. The tenant pays these expenses, for their pro rata portion of the building.

Caps on Increases?

Some leases also provide a cap on increases in expenses. Expanse caps often address the total expenses. Some expense caps are more detailed and include limits on individual line item expenses. To provide more certainty for the tenants cost of occupancy, the tenant may request that property tax increases do not exceed 5% in any year. Property tax increases can be enormous in some states. For example, initial property tax assessments in Texas for office buildings have increased by 20% to 100% for many office building owners. In many cases, these large initial assessments have been successfully reduced to a level much closer to the prior year's value.

Cap Example

However, the property tax assessment process can be arbitrary at times. If the property taxes did increase by 20% or 100%, the landlord would be responsible for the increase in excess of 5% for the example given. There are also sometimes expense escalation caps for utilities, insurance, total expenses and other items.

Eminent Domain

Eminent domain is the right of government to take private property. Historically, eminent domain was limited to taking private property for public purposes. However, the US Supreme Court expanded eminent domain to include taking private property for private uses. In most cases, property owners are compensated for "takings" through eminent domain.

Eminent Domain Issues

Issues related to leasing office space include who retains compensation for a leasehold estate, what happens if eminent domain takes an amount of parking which makes operation of the office building impractical and if there any rental abatements during construction related to a partial taking of the office building.

Leasehold Estate

A leasehold estate is a tenant's interest in real estate obtained through a lease. A leasehold estate becomes meaningful when contract rent is substantially lower than market rent. Having the right to use office space for a payment well below market rent has value. In the event of a complete taking (when the government takes the entire office building) the lease needs to address proceeds of the tenant's leasehold estate. Do they belong to the tenant or to the landlord?

Partial Taking

In any "partial taking", the government only takes a portion of a property. This may or may not include any portion of the building. For the sake of discussion, let's assume a office building with 100,000 ft. and 350 parking spaces. The 350 parking spaces are along the street in front of the building. The current amount of parking is just barely adequate. The condemnation will "take" 200 parking spaces along the street. This leaves the property with only 150 parking spaces, or less than half of what is necessary. The lease needs to define the rights and responsibilities of both the tenant and the landlord in event of a partial taking.

In Event of Foreclosure

Foreclosure of a mortgage typically extinguishes all claims to the property. In other words, if you've negotiated a lease and started a business, your right to use the office space is terminated by foreclosure unless there is a separate agreement.

Will Lender Cancel?

In many cases, depending upon state law, the lender has a defined period of time to reject leases or they are assumed to remain intact. Further, lenders often want to retain the leases and tenants to make the property more salable. However, if the rental rate for a lease is well below market rent, and the tenant is clearly successful, the lender might terminate the lease and require the tenant to negotiate a new lease at market rent.

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